If you’re an entrepreneur looking to raise finance for your business, you may be considering onboarding an investor such as venture capital or private equity firm. If that’s the case, you’ll most likely come across a variety of different legal documents as part of the funding transaction, one of which is an investment agreement.
An investment agreement is a contract between the company and its investors. While it is similar to a shareholders agreement, there are several key differences.
In this guide, we explain the purpose of investment agreements, their key terms, other documents you may encounter as part of the investment arrangements, and the differences between shareholders and investment agreements.
While we strongly advise you to take expert legal advice before entering into an investment agreement, understanding its terms is a valuable part of any successful entrepreneur’s business toolkit. This document can protect your company and create certainty around your relationship with a new investor.
- What’s an investment agreement?
- Why are investment agreements important?
- Types of Investment Agreement
- What’s the difference between investment agreements and shareholders agreements
- What are the main terms of investment agreements?
What’s an investment agreement?
Where an investor such as a venture capital firm or even an existing investor is proposing to inject new capital into your business, they will likely require you to sign a contract known as an investment agreement.
An investment document is an important document as it sets out the key terms of the investment, such as:
- The identity of the company and the investors
- The amount being invested
- Any conditions on which the investment is being made
- Whether there are any preconditions to the investment, for example, that shares will be issued in return for the investment
- Warranties given by the investor and the company
The precise terms of the investment agreement will depend on the type of funding being offered.
Why are investment agreements important?
When your company accepts new funding, both itself and your investors take on certain risks inherent in the transaction. An investment agreement helps both sides identify and manage these risks in a mutually acceptable way. This can be particularly important to start-up companies and companies going through early rounds of investment to ensure that all parties are clear on the terms of the investment, both now and in the future.
An investment agreement creates legally binding arrangements that allocate risk and the rights and obligations of each party, including provisions that govern what to do in case of a dispute, or one side wants to exit from the investment arrangements.
Investors that are going to be minority shareholders, in particular, will want to make sure the funds are used in the way envisaged, and that they have an adequate say in the company strategy.
Ultimately, investors are seeking to make sure there’s a legally binding document that sets out how they will get a return on their investment.
Types of Investment Agreement
The type and terms of your investment agreement(s) will depend on the type of funding being offered to your company. Here are the most common types of investment arrangements:
Share purchase agreement
If your company is issuing shares as part of the investment, then you’ll enter into a share subscription agreement with your investor under which they agree to purchase shares in exchange for their investment.
Convertible loan note
If your investor has chosen to make your company a loan that may convert into shares later, then your company will issue a convertible loan note in favour of the investor.
Simple agreement for future equity
If your investor wants the right to subscribe for shares in the future, they may ask you to enter into a simple agreement for future equity or SAFE in return for providing funding.
What’s the difference between investment agreements and shareholders agreements
While both investors agreements and shareholders agreements are contracts between investors and a company, in contrast to an investors agreement, the shareholders agreement sets out how the company will be governed and how decisions are made. Among other things, it may include:
- Who can appoint directors
- How and when new shares are issued, and to whom
- How shareholders can sell or transfer shares
- What information the company must disclose to shareholders
- How and when the shareholders can have a say in the way the company is run
Because the shareholders agreement will affect investors’ rights in their capacity as co-owners of the company, they’ll be interested in its contents and require input when it’s being set up. However, there are many key differences between shareholders agreements and investment agreements.
The document’s main purpose
The main purpose of an investment agreement is to set out the terms of the investment, for example, any pre-conditions to funding and what promises are given in return for the money. In contrast, the shareholders agreement’s purpose is to describe decision-making arrangements, and what control, if any, the shareholders have in the way the business is run.
An investment agreement relates only to the particular investment transaction. A shareholder agreement’s scope is broader, and covers many aspects of company administration, such as the issuing of shares and decision-making.
The parties to an investment agreement are the company and the investor. A shareholders agreement is between the company and all its shareholders, including the investor(s), if they are to become a shareholder as a result of the investment.
Impact on the business
An investment agreement will set out the company’s obligations and warranties to the investor in return for the funding. The investor will not usually have any input into the company’s affairs unless they are also becoming a shareholder.
A shareholders agreement on the other hand will contain ongoing obligations to the shareholders in relation to its business affairs. Certain key decisions such as whether to borrow money or acquire assets may require consent from the shareholders.
What are the main terms of investment agreements?
While each investment agreement is different, here are the main terms
The identity of the parties
If an investor will be subscribing to shares in the company in return for the investment, or will require shares be issued to someone else on its behalf, the person will need to sign the investment agreement and any shareholders agreement.
If there’s more than one investor, or there’s a syndicate of investors, then all investors, or a duly appointed representative, will become part of the investment agreement.
A ‘tranche’ is a portion or segment of the funds being advanced. Tranches of funding may be tied to the company meeting certain conditions or reaching certain milestones. There may also be trigger events that must occur following the first tranche of funding, or before another tranche becomes available to the company.
The investment agreement should set out how many tranches of funding there will be, the amount of those tranches, and whether any conditions are attached to those tranches. The agreement should also describe what will happen if those conditions are not met or not met by a certain deadline.
A common right for investors is the ability to waive or amend conditions if the company doesn’t reach the scheduled milestone. Some common conditions to a first tranche being advanced are the completion of due diligence, regulatory clearance and the signing of related documents. The investment agreement may contain restrictions on what funds may be used for (a particular project for example).
Some common conditions for further tranches include relevant milestones having been achieved, that there’s been no material adverse change to the financial status of the business and that the company remains solvent.
The investment agreement should also state how the investors’ return will be calibrated (issue of shares, payment of an interest rate or a return rate, for example) and when repayment (if any) of the investment should start
It is common for the investors to ask the company and its directors/management for warranties as to the company’s performance and status so that they can mitigate against the risk that the company is not as attractive as it appears.
A warranty is a statement that facts or circumstances about a company are true at a certain point in time. If a warranty turns out to be untrue, then the party relying on the warranty may be able to claim damages if it suffers a loss as a result.
Sometimes investors negotiate fixed damages that are payable if there’s a breach of the warranties and these are designed to be genuine pre-estimates of loss. They’re designed to make the claiming process quicker and simpler (these damages are often referred to as ‘liquidated damages’).
Investors with bargaining power may ask for the warranties to be repeated at completion, as well as at signing (or may ask for warranties to be repeated prior to each tranche being released). This gives investors further protection as it means that the warranties are accurate at the time funding is released.
Investors with bargaining power may also ask for clauses that give them an exit route if there’s a materially adverse change in business conditions.
A company is wise to push for a cap on the total amount of warranty claims an investor may make, and additional caps on individual liability of directors or management. Usually warranties also have a monetary limit that must be reached before a claim can be brought by an investor.
An investor may be entitled to a seat on the board of directors or the right to observe company board meetings. These rights will also need to be set out in the company’s Articles and any shareholders agreement.
Depending on what is set out in the company’s articles of association or shareholders’ agreement, the investor may be able to appoint one or more directors to the board at some point during or following the investment and may be able to demand that board meetings must contain those investor directors in order to be considered to be validly held.
The directors may also decide on a set of ‘reserved matters’ — decisions that can’t be taken without the consent of the investor director, in effect giving the investor director a veto right.
You could be careful before giving seats on the board or surrender control of the way the company is run. This can make it harder to operate the company and achieve the company’s strategy. In most cases however, the cost of receipt of a large investment is the sharing of the management decisions of the company and in the case of investment by experienced investors, this level of involvement may be welcomed.
Under the Companies Act 2006, any director the investor appoints will have to comply with its obligation to act in the best interests of the company and its shareholders as a whole. The investor director will need to declare any conflicts of interest between the investor and the company.
The company may agree to include promises (called restrictive covenants) in the investment agreement in exchange for the investment. For example, the company’s management. May agree not to compete with the business, and promise that its key personnel won’t leave the business to join a competitor within a certain amount of time after the investment has been made.
These covenants are designed to protect the investor’s investment and to ensure that there is not a deterioration in the quality of management of the company or the trading and commercial position of the company immediately after the investment is made.
The parties will want to ensure that the investment agreement contains confidentiality provisions that protect the sensitive commercial information of the parties, and deals with who can make announcements and publish information about the investment or the investment process.
It is important to include an exit strategy in the investment agreement in case there’s an unresolvable dispute between the parties, or if the investor wishes to stop investing or transfer its shares, or the company becomes insolvent.
The investment agreement will describe what happens to the departing party’s shares (for example, if they have to be offered to the shareholders or the company itself before they are offered to an independent third party). The investment agreement should also be clear on how the investment is paid back (if at all) if the company becomes insolvent.
The parties may plan for an exit, such as an IPO or sale, and the investment agreement should make clear what process shall be followed at such time.
For more answers to commonly asked questions and advice on investment agreements, consult our corporate solicitors. Get in touch on 0800 689 1700 email us at firstname.lastname@example.org, or fill out the short form below with your enquiry.